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Stock options were originally intended to tighten the link between executive pay and performance. In practice, however, they've proven to be a clumsy tool. In the bull market of the 1990s, options enriched many a mediocre CEO, while the economic slump that opened this decade has punished weak and strong performers alike.

Conventional options have that effect because they focus on absolute performance. As a result, they both reward and punish managers for factors, such as market movements, that are beyond their control. In order to filter out these effects, many analysts have suggested that companies scrap their existing programs in favor of indexed options. Under one such proposal, companies would reset the price of their options each year in order to reflect changes in a market benchmark, such as the S&P 500. If the index rose 10%, for example, the exercise price would also increase by 10%, allowing a CEO to cash in only if his share price had grown by even more.

The idea behind indexed options is to reward executives who outperform the market or industry peers. But as Harvard Business School finance professor Lisa K. Meulbroek demonstrates in a December 2001 working paper, they fail to achieve that goal. A simple example makes this clear. Say an executive receives an option with a $10 strike price, and the market price of the stock is initially $12, giving the option an “intrinsic value” of $2. One year later, the company and the market have both gained 10%, making the share price $13.20 and the strike price $11. If indexing worked as intended, the option's intrinsic value would remain the same. In fact, however, at $2.20, it has also risen 10%.

A similar result holds for options granted at-the-money — that is, when the exercise price and the market price are initially the same. In this case, the option's intrinsic value is zero, but it is still worth something — say $1 — because part of an option's total value stems from uncertainty about future price movements. Consequently, if the market and the company both gain 10%, the option's value increases by the same amount. More generally, changes in the option's value do not match the company's performance relative to the market.